The old saying about the worm finally turning is based on the notion that even the most timid wee beastie, such as a worm, will eventually reach its limit when under attack and turn on its tormentors. This idiom refers to the idea that in human affairs, a situation can suddenly change so that a person or group of people who’ve been weak, unlucky, or unsuccessful can become strong, lucky, or successful (Merriam-Webster online dictionary, 2018). An example from market history springs to mind: the ascendancy of tech stocks in the great NASDAQ bubble of the late 1990s, and the corresponding collapse of investor enthusiasm for valuation analysis or value investing. Huge market capitalizations were awarded by the markets to companies that had never made any money (e.g., Global Crossing, worth a peak value of $47 billion in spite of no net income; Wikipedia, 2018a). Others (e.g., Pets.com; Wikipedia, 2018b) had great publicity and name recognition, and even made a little money on operations, but spent 19 times their net income on advertising alone. They sold their popular merchandise at a huge loss, yet still attracted big investors on Wall Street. Still others had explosive IPOs (e.g., eToys.com, which had an opening day stock offering priced at $20/share and hit a peak of $84.35/share a few months later) but went deeply into debt almost immediately, and later foundered (Wikipedia, 2018c).
While all of this was going on back in the late 1990s, value investing fell out of favor. This can easily be seen in Chart 1, taken from a recent article on Seeking Alpha (Charlie Bilello, 2018). Growth (as measured by the Russell indexes) outperformed value by about 145% at the market peak in 2000. However, once the sell-off happened starting later in 2000, the Russell 1000 value index (RLV) outperformed the Russell 1000 (RUI) all the way until late 2011, on a rolling ten-year basis. Indeed, over very long time periods, value under a variety of definitions tends to outperform growth (Chart 2), especially when small cap stocks are the value stock investment vehicle.
Chart 1: Growth Outperformed Value in Late 1990s and Recently
Chart 2: Out-performance by Small Cap Value vs. Growth (1965-2014)
Even if we look at large cap stocks alone, thus removing the small cap stock effect (Chart 3), there remains a long term relative performance spread in favor of value stocks amounting to 5%. If we examine the three Russell indexes (RLV, RLG, and RUI) over the time period from 1996 to 2018, we again see out-performance by value in spite of the great ten-year rally we’ve been in (Chart 4). Still, in the shorter run there have been significant periods where the relative under-performance of value stocks can reach alarming levels (Euclidean Technologies blog, 2015). This can be equivalent to at least two standard deviations of relative under-performance at times (Mauldin Economics, 2018), so it is very hard to take. Indeed, most people could not tolerate lagging behind by such amounts, and the markets often reflect this as people chase returns. Note also that the current episode of under-performance by value stocks is almost three standard deviations in relative terms (the highest ever), using the Fama and French data set of Mauldin Economics in their ValueWalk article; it is also the longest such episode ever.
Chart 3: Out-performance by Value vs. Growth (1964-2015) by Quintile Based on Two Value Measures
Chart 4: Out-performance by Russell Value (RLV) vs. Russell 1000 (RUI) and Russell Growth (RLG) (1996-2018)
Some measures of value such as price/book value are out of favor now (Chart 5) after under-performance over a long period (Euclidean Technologies blog, 2015; also Paul Novell, 2017). However, both EV/EBITDA and P/E still work well as value measures. As already stated, there are other proxies or measures of value that work also. The question now is, after this huge under-performance in recent years (Chart 6), are we finally seeing a chance to do substantially better with value stocks going forward? Many have already suggested that the answer is yes, so no news flash there. Several factors do appear to signal a switch in the dominant investment theme that is consistent with late cycle or bear market trends usually observed historically. For example, the RLV index outperformed the RLG index by 2.08% during the recent October 2018 sell-off. Various tech high fliers in the so-called “FANGMAN” bubble-stock growth universe, such as Facebook (FB), Nvidia (NVDA), Alphabet aka Google (GOOGL), Amazon (AMZN), and Netflix (NFLX) have all sharply under-performed the Russell 1000 value index (RLV) in recent months (Charts 7-11).
Chart 5: Out-performance by EV/EBITDA and P/E Value Measures, with Under-performance by P/BV (1983-2016)
Chart 6: Out-performance by RLG vs. RLV Over Five Years
Chart 7: Recent Out-performance by RLV vs. FB
Chart 8: Recent Out-performance by RLV vs. NVDA
Chart 9: Recent Out-performance by RLV vs. GOOGL
Chart 10: Recent Out-performance by RLV vs. AMZN
Chart 11: Recent Out-performance by RLV vs. NFLX
If the market sell-off continues, or a bear market becomes official, or the late cycle call is further confirmed by further declining forward-looking economic data, then recent investor behavior with regard to value stocks is signaling that it’s finally their turn. Investors who believe a bear market is coming or has already started will do much better over the coming quarters by de-emphasizing growth and re-emphasizing value in their portfolios. Growth investors who hold what are still, even after the sell-off, highly over-valued and over-owned popular growth stocks will not like what happens next if my thesis is right.
Those who accept the notion that value stocks will now enjoy relative out-performance vs. growth stocks should buy the DoubleLine Shiller Enhanced CAPE Fund (DSEEX), the Fidelity Low-Priced Stock Fund (FLPSX), and/or the Vanguard High Dividend Yield Fund (VYM). Given the current long-term sell-off from the January market high, the renewed sell-off from the October market high, and the state of certain national economies, it makes sense to invest some money in a gold fund like SPDR Gold Shares (GLD), but only as a short-term hedging trade, not a buy-and-hold position. The I-Shares Gold Trust (IAU) is an alternative ETF that may be safer for those who want to hold it for a somewhat longer period of time. But the safest form of gold in the event of a true financial apocalypse is physical gold. Also, for those discounting a possible near-term recession and bear market, some liquid alternatives like the Otter Creek Prof. Mngd. Long/Short Portfolio (OTCRX) could be held to protect assets in the event of a much sharper market draw-down associated with deteriorating economic data. Those in a more defensive frame of mind because of the expected eventual market slide should also hold some long Treasuries, in spite of bearish arguments to the contrary, as a stock market crash would be hugely supportive of bond prices: examples include the Wasatch-Hoisington Treasury Fund (WHOSX), and the I-Shares 20+ Yr. Treasury Bond ETF (TLT).
Disclosure: I am/we are long GLD, OTCRX, WHOSX, TLT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Disclaimer: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks or other securities mentioned or recommended. This post is illustrative and educational and is not a specific recommendation or an offer of products or services. Past performance is not an indicator of future performance.